Why Oil Prices Are Likely to Remain High

Last year was a good year for oil. The price of Brent crude, the global benchmark for oil, remained above $100 per barrel for most of the year. But now, as a new year kicks off, people want to know whether oil prices are headed higher or lower.

It's certainly an important question. Not just for oil companies, but for consumers and other businesses as well. While it's true that commodity prices are virtually impossible to predict with a high degree of accuracy, there is compelling evidence that oil prices should remain high.

Or, to look at it a different way, there is good reason to believe that they are at least unlikely to fall below a certain threshold level. Let's take a closer look at why.

Determinants of the price of crude oilThe price of Brent crude reached a three-month high last week, bolstered by a string of optimistic global economic data and geopolitical concerns about North African oil supply in the wake of a terrorist attack in Algeria. ICE March Brent crude rose to nearly $114 a barrel on Friday and started off this week at levels above $113 a barrel.

Brent prices have risen nearly 2% since the start of the year, as recently released economic data from the U.S., China, and the eurozone have instilled a renewed sense of optimism about the global economy. Concerns about North African supply, as well as reduced production from Saudi Arabia, have also contributed to the slight increase in prices.

While there are a host of factors that impact crude oil prices, such as global supply and demand fundamentals, geopolitical risk, speculation, and monetary policy, marginal production costs have proven to be a remarkably accurate indicator of the price of oil. In fact, according to a note by Bernstein Research, the marginal cost of production is "the most important factor driving oil prices over the long run."

The relationship between the price of oil and the marginal cost of oil production, which refers to the expenses associated with producing the last barrel, is well documented. For instance, between 2001 and 2010, the average annual price of Brent increased 228%, while marginal production costs among the world's 50 biggest public oil companies rose 229%, according to calculations by Bernstein Research.

It boils down to the incentives facing oil companies. If the cost of producing that last barrel of oil exceeds the price they can get for it, they have no financial motivation to produce it. Herein lies the first major clue as to the future direction of oil prices – production costs have risen sharply in recent years, which, some argue, has effectively placed a floor below the price of oil.

Spike in production costsThe Bernstein Research note analyzed production costs for the 50 biggest publicly traded oil producers and found that cash, production, and unit costs in 2011 increased at a rate much higher than the 10-year average.

Specifically, they found that production costs in 2011 rose 26% year over year, while the unit costs of production rose by 21% year over year, coming in at $35.88 per barrel. Among the 50 oil producers surveyed, the marginal cost of production rose 11% year over year, coming in at a whopping $92 per barrel in 2011.

Energy companies are well aware of this development and have been doing everything they can to protect themselves, including major initiatives to lower costs. For instance, Halcon Resources(NYSE:HK) is planning dramatic cost reductions in 2013 to help offset the relatively high operating costs of its mature producing assets.

Meanwhile, Kodiak Oil & Gas(NYSE:KOG) has already seen a dramatic reduction in operational expenses through improved fracking techniques, which has led to a sharp decline in the number of days taken to drill a well. And LINN Energy(NASDAQ:LINE), through water-management initiatives, has benefited from major expense reductions in its Granite Wash and Permian Basin operations.

Why productions costs have risenThe reason production costs have increased so sharply has to do with changes in the marginal source of supply. A few decades ago, U.S. oil producers could easily extract oil for under $20 a barrel, but those days are long gone. As fields of so-called "easy oil" have quickly been depleted, energy companies have been forced to venture out of their comfort zone and into new and harsh terrain in the pursuit of black gold.

For instance, Royal Dutch Shell is hoping to drill for oil off the coast of Alaska – a plan that has received intense scrutiny and opposition by environmental groups, as well as the CEO of Total. Similarly, ExxonMobil(NYSE:XOM) and Statoil(NYSE:STO) are planning to explore for oil in the harsh Arctic waters near Russia.

These examples are illustrative of a major shift in global oil supply and suggest that the world is becoming increasingly reliant on unconventional sources of oil, such as shale and deepwater. While these unconventional sources hold vast promise in terms of the quantity of potentially recoverable hydrocarbon resources, they are accompanied by exorbitantly high costs due to the need for more technologically sophisticated equipment.

Final thoughtsBecause oil prices are determined at the margin, the net impact of this shift toward unconventional sources has been upward pressure on crude prices. Despite media coverage suggesting that oil companies are raking in more cash than they know what to do with, the evidence suggests that high marginal production costs are taking their toll on even the most expertly managed operators.

There are other factors at play here, too. OPEC member countries, which account for more than a third of global oil production, have incentives to maintain oil prices above a certain threshold. For instance, Saudi Arabia probably requires oil to be at least $80 a barrel in order to keep its budget in order. Other important players in the global oil market, such as Russia and Venezuela, have similar minimum requirements.

All in all, the world is becoming increasingly more dependent on unconventional sources of oil. Currently, unconventional oil accounts for a relatively paltry 3% of global supply, but by 2020 it is projected to account for about 7%, and by 2035, 10%, according to the U.S. Energy Information Administration. Since unconventional oil is much costlier to extract, its associated higher production costs should continue to exert upward pressure on global oil prices, helping maintain prices above a certain threshold.

Author

Arjun is a value-oriented investor focusing primarily on the oil and gas sector, with an emphasis on E&Ps and integrated majors. He also occasionally writes about the US housing market and China’s economy.